USING PRIVATE MORTGAGE INSURANCE WHEN YOU HAVE THE …

USING PRIVATE MORTGAGE INSURANCE WHEN YOU HAVE THE 20% DOWN PAYMENT

John B. White, Ph.D.

Professor of Finance United States Coast Guard Academy john.b.white@uscga.edu 860-941-5784

Using Private Mortgage Insurance When You Have the 20% Down Payment

White

ABSTRACT

Private mortgage insurance (PMI) is required on conventional mortgage loans when the down payment is less than 20% of the home's purchase price. The common wisdom suggests that private mortgage insurance is a waste of money and should be used only if assembling a 20% down payment is impossible. However, this common wisdom ignores the return that funds would earn if invested instead of being used for a 20% down payment. This study examines the returns resulting from making a down payment of less than 20% and investing the difference. The results indicate that in many cases, it is financially advantageous to make a down payment of less than 20%, pay the PMI, and invest the balance.

Key words: Private mortgage insurance (PMI), Home mortgages, Home financing, Down payments

Economics & Business Journal: Inquiries & Perspectives

Volume 9 Number 1 2018 57

Using Private Mortgage Insurance When You Have the 20% Down Payment

White

INTRODUCTION

If you look at lists of "How to Buy a House," nearly all will advise the buyer to accumulate a down payment fund equal to 20% of the anticipated home's purchase price. The goal here is to avoid paying private mortgage insurance, which would be required on a conventional loan with a loan-to-value ratio greater than 80%. Mortgages with a down payment of less than 20% have proven to have a higher probability of default, and therefore the buyer is generally required to purchase private mortgage insurance (PMI). The annual cost of PMI can range from 0.5% to 1.0% of the mortgage loan. On a $200,000 house with a 5% ($10,000) down payment, the annual PMI would be between $950 and $1900, or anywhere from an additional $79 to $158 a month. And these payments continue until the loan-to-value is below 80%.

PMI is most often viewed as money thrown into a pit, which is why buyers are encouraged to avoid it if at all possible. Other than an aggressive saving plan to accumulate a down payment, buyers are encouraged to explore other sources to augment their down payment. Private loans and gifts from relatives are a common source.

Another down payment source is what is referred to as a piggyback loan. With a piggyback loan, the buyer finances 80% of the home's value with a conventional mortgage, and then borrows the balance required in a second loan that "piggybacks" on the original mortgage. Since the mortgage is 80% of the home's value, no PMI is required, which is a real advantage. Another is that most piggyback loans require only interest payments on the loan. This means that at the termination of the loan, the principle must be repaid or refinanced. A downside of piggyback loans is their rates a usually tied to the prime rate, which means the rate (and associated payment) may vary (Murad 2015). This implies that the decision on a piggyback loan versus PMI comes down to a comparison of the expected payments.

What is absent from the discussion is should a buyer who has the ability to make a 20% down payment consider putting less down and pay the PMI? This question essentially asks, "What is the opportunity cost of the funds used in the down payment?" Obviously, the opportunity cost of this money is the return that they could have earned if those funds had been invested rather than being included in the down payment. Viewed in this context, the PMI can be considered the incremental cost that permits you to continue to earn interest income on the funds that could have been your down payment. To be complete, a comparison of rates of return should be conducted on an after-tax basis. However, PMI premiums are not tax deductible under the current tax regime. In addition, down payments usually are withdrawn from savings accounts where the interest earned is taxable. Since neither has a tax advantage over the other, this analysis is done on a pre-tax basis.

This analysis calculates the cost of the PMI as an interest expense on the amount of the mortgage loan in in excess of 80%. To meet the 80% loan-to-value ratio, a

Economics & Business Journal: Inquiries & Perspectives

Volume 9 Number 1 2018 58

Using Private Mortgage Insurance When You Have the 20% Down Payment

White

$200,000 house would require a down payment of $40,000 and a $160,000 mortgage. However, if the down payment is only $10,000 (5%), the mortgage is $190,000. The PMI can be considered the additional cost on $30,000 of the mortgage. The question for the homebuyer is what they can expect to earn on the money not invested in the house.

ASPECTS OF PRIVATE MORTGAGE IINSURANCE

The real requirement for private mortgage insurance comes not from the mortgage company but rather from securitization requirements of Freddie Mac and Fannie Mae. These federal agencies are not allowed to buy any mortgage with a loan-to-value ratio of less than 80%, unless those mortgages contain specified "credit enhancements," the most common of which is PMI. Conventional mortgage borrowers are required to pay the PMI monthly until the loan-to-value ratio is 80%. Once the loan-to-value ratio is 80%, the borrower may request the cancellation of their PMI (Fannie Mae, 2017). The PMI must be cancelled once the loan-to-value ratio reaches 78%.

The loan-to-value ratio will obviously decline over time as payments are made. Any appreciation in the value of the home will also reduce the ratio. The mortgage lender usually requires a new professional appraisal of the home if the borrower is trying to establish a new property valuation, as this is the denominator in the loan-to-value ratio. The cancelation of the PMI assumes the borrower has had no payments more than 30days late in the last year, or 60-days late in the past two years. Late payments can make PMI more difficult to cancel, even once the normal cancellation requirements have been met (Fannie Mae, 2017).

The level of the PMI payment depends on the loan-to-value ratio and the applicant's credit score, as both of these figures effect the risk of default. The closer the down payment is to the 20% figure, the lower the PMI. Likewise, the higher the credit score, the lower the PMI (Freddie Mac, 2015). Table 1 demonstrates how the monthly PMI payment on a 30-year mortgage at 4% for a $200,000 house varies with the amount financed and the buyer's credit rating. The PMI figures are from the HSH's PMI Calculator (HTH, 2014). As Table 1 in Appendix A indicates, a larger down payment can compensate for a lower credit rating. This suggests that insurers perceive that more risk is associated with a smaller down payment than a poor credit history.

LITERATURE REVIEW

Much of the discussion concerning private mortgage insurance, especially in the popular press, seems to center on why it should be avoided and how it can be avoided. Dave Ramsey, a popular financial advisor, suggests a potential home buyer save enough to make a 20% down payment to avoid PMI. He states that PMI is "an extra cost that doesn't go toward paying off your mortgage..." (Ramsey 2017). Another writer echoes these sentiments, stating PMI can be a significant amount of your monthly payment but provides very little in return. Unlike most insurance, where your premium payment protects you from some risk, your mortgage insurance protects the lender in the event of your default (Curtis, 2016).

Economics & Business Journal: Inquiries & Perspectives

Volume 9 Number 1 2018 59

Using Private Mortgage Insurance When You Have the 20% Down Payment

White

If you lack the funds for a conventional 20% down payment, one way to avoid paying PMI is to use a piggyback loan. A piggyback loan is essentially a second loan (in addition to the mortgage) on the house to fund a 20% down payment (Murad, 2015). These loans are similar to home equity loans, having a variable rate and requiring an interest only payment. Piggyback loans generally carry a higher interest rate than conventional mortgages. However, it may be less costly to make the payment associated with this higher interest rate than to pay the PMI premium on the entire mortgage. In addition, the piggyback loan terminates automatically when it is paid off, while removing the PMI payment is more complex (Simon, 2006).

Eckles, Halek, and Wells (2006) also address the question of home buyers that lack the requisite 20% down payment. Using a 10% down payment, they compare standard monthly PMI payments with a single, upfront PMI payment as well as with the payments required on a piggyback loan of 10%. Not surprisingly, they find that that the optimal mortgage policy depends on interest rates. A piggyback loan is the best option for buyers that qualify for this additional level of debt. For those that cannot qualify for a piggyback loan, monthly PMI payments are better if your plan is to own the house for less than five years. If your ownership horizon exceeds five years, then the single PMI premium payment is more advantageous. This analysis is extended by Hatem, Paul and Wells (2009) by including the tax deductibility of PMI payments. Using the 15% marginal tax rate employed by the earlier study, they found that the monthly PMI payment was more advantageous than the 10% down-10% piggyback loan. The tax deductibility of PMI payments recently expired, making these results moot when deciding on a down payment strategy for buying a home (Koreto, 2018). (It is a popular deduction, however, and could possibly be restored in the future. A bill was recently introduced in Congress to make the tax deductibility of PMI payments a permanent feature of the IRS tax code (Mortgage Insurance ..., 2018).)

METHODOLOGY AND ANALYSIS

All of these studies assume that the home buyer lacks sufficient funds for a down payment and is forced to into private mortgage insurance or a piggyback loan. Just because a buyer has the cash to make a 20% down payment is no reason that they are required to do so. It also does not mean that they SHOULD do so. Making a significant down payment allows the buyer to avoid PMI expenses, and these PMI charges essentially raise the cost of the loan. But this avoidance of these PMI expenses also comes at a cost. The money used in the down payment is no longer available as an interest earning asset. Assuming that you have the funds for a 20% down payment, a more prudent approach to financing the house is to compare the interest cost of the PMI with the interest that the down payment funds could earn if not used to purchase the house.

This study views the PMI as a cost of the lower down payment rather than merely a penalty for not having sufficient funds to cover a 20% down payment. As a cost, it should be compared to the corresponding revenues associated with the transaction. The question then becomes: What is the effect of the PMI payment on the cost of the

Economics & Business Journal: Inquiries & Perspectives

Volume 9 Number 1 2018 60

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